SU9: Investment Decisions Flashcards
Stages of Capital Budgeting
- Identification and Definition
- Search
- Information-Acquisition
- Selection
- Financing
- Implementation and Monitoring
Steps in ranking investments
- Determine asset cost or net investment
- Calculate estimated cash flows
- Relate the cash flow benefits to their cost
- Rank the investments
Hurdle rate
Minimum rate of return on a project or investment that an investor is willing to accept
Salvage value note…
Salvage value is never subtracted when calculating the depreciable base for tax purposes. General rule - the new equipment will result in higher depreciation than the existing equipment. This tax savings is the dax depreciation shield.
Ordinary annuity
end of each period. also known as annuity in arrears.
annuity due
beginning of each period. also known as annuity in advance.
certainty equivalent
certainty equivalent - at what point a firm is indifferent to the choice between a certain sum of money and the expected value of a risky sum
Monte Carlo Simulation
generate the probability distribution of all possible outcomes from a capital investment.
Two most widely used rates for discounts rates
- weighted average cost of capital
2. shareholders opportunity cost of capital
IRR equation
rate at which the initial investment is equal to the NPV of annual cash flows
Payback period
initial net investment / annual expected cash flow
undiscounted payback periods are always <> than discounted payback periods
faster
bailout payback method
incorporates the salvage value of the asset into the calculation/measures the risk if a project is terminated.
payback reciporical
1 divided by payback
profitability index
present value of future net cash inflows divided by the present value of the net initial investment
when to use profitability index
if index greater than 1, then accept
if less than 1, then reject
Internal capital market
a way of referring to the provision of funds by one division of a firm to another division. A division operating in a mature industry that generates a lot of cash can provide funding to another division that is in the cash-hungry development stage.
Linear programming
a technique (now usually computerized) for optimizing resource allocations so as to select the most profitable or least costly way to use available resources.
Identify three weaknesses in using payback period
- ignores cash flows after calculated payback period
- payback period does not discount future cash flows, tehrefore ignoring time value of money
- choice of cutoff period is arbitrary.
Identify three techniques or methods that can be used to quantify and assess risk
Sensitivity analysis, breakeven analysis, risk adjusted discount rates, monte carlo simulation, decision trees, certainty equivalent
Technique for evaluating projects when capital is rationed and there are no mutually exclusive projects from which to choose
Profitability index
The rankings of mutually exclusive investments determined using the internal rate of return method (IRR) and the net present value method (NPV) may be different when
Multiple projects have unequal lives and the size of the investment for each project is different.
Under what circumstances does the IRR become misleading?
When the direction of cash flows changes (positive in year one, negative in year two OR negative in year one and positive in year 2) AND when the hurdle rate lower than the rate at which two projects have the same return
A company should use the profitability index instead of the net present value method to rank investment projects when the investments have
different initial costs
A corporation has not yet decided on hits hurdle rate for use in the evaluation of capital. This lack of information will prevent the corporation from calculating a projects…
Net present value (but NOT Accounting Rate of Return, Internal Rate of Return)
Which capital budgeting technique would result in the same project selection as the net present value method
Profitability index
